Long-term Incentive Effects of Executive Stock Options

Abstract

Although stock options have been widely used as part of firms’ long-term incentive plans, rarely has any study examined whether stock options indeed achieved the intended long-term incentive effect. This study for the first time examines whether stock options have motivated executives to take a long-term perspective of the firms. This question is addressed by examining how executives perceive the value of underwater options, which is revealed by the changes in firms’ new option grants that followed the deep stock price decline in the most recent financial crisis of 2008. It draws on prospect theory and complements rational option valuation methods by incorporating behavioral perspectives in executives’ stock option valuation. Contrasting hypotheses regarding firms’ new option grants in response to the losses from underwater options are developed under three assumptions: (1) “short-term view of executives”, (2) “long-term view of executives” and (3) “behavioral view of executives”. The results of the regre...